Video: Crowding Out in Economics: Definition & Effects

Financial resources are limited, and there isn't always enough to go around. In this lesson, you'll learn about the economic concept of crowding out, including what it is and its effect. A short quiz follows the lesson.

Financial resources are limited, and there isn't always enough to go around. In this lesson, you'll learn about the economic concept of crowding out, including what it is and its effect. A short quiz follows the lesson.

Definition of Crowding Out

Crowding out is a situation where personal consumption of goods and services and investments by business are reduced because of increases in government spending and deficit financing sucking up available financial resources and raising interest rates. Crowding out can be caused by an expansionary fiscal policy financed by increased taxes, borrowing, or both. Let's look at this in a bit more detail.

Effects of Crowding Out

Crowding out creates at least three problems. First, an expansionary fiscal policy means that the government is using financial resources that are no longer available for use by individuals and businesses. If the spending is financed through raising revenue through taxation, then that means there will be fewer dollars in the pockets of individuals and businesses to use for spending and investment. Additionally, if the government is competing for goods and services along with individuals and business, it may result in Increased prices because of the increase in demand.

The problem may be compounded if the government finances its spending through borrowing. The sheer size of a government's borrowing may create upward pressure on interest rates as the private sector and public sector compete for loans. This will make financing more expensive, which will have a negative effect on private economic growth. If it costs too much to obtain financing, individuals will decide not to purchase and businesses will decide not to invest.

The combination of the first two problems leads to the overarching problem with economic crowding out—dependency on government spending for economic stability and growth. If government spending takes up a sufficient amount of financial resources and constitutes a sufficient amount of the overall consumption and investment in a country, then the country's economy may become dependent upon it. The United States government, for example, spends trillions of dollars a year. What do you think would happen to the U.S. economy if the United States stopped spending tomorrow?

Lesson Summary

Crowding out is an economic concept that describes a situation where personal consumption of goods and services and investments by business are reduced because of increases in government spending and deficit financing sucking up available financial resources and raising interest rates. The costs of resources and interests rates increase as the private sector competes with the public sector for the resources and financing. If public sector spending becomes significant enough, a country's economy may become dependent upon government spending to maintain economic stability and growth.

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